OFF THE SHELF; Demystifying the Fund Universe

By PAUL B. BROWN

Published: April 10, 2011

IT is amazing how little many of us really know about our mutual funds.

We may have a handle on the investments they hold -- large-cap stocks or bonds or whatever -- and some understanding of how they work: our money is pooled with a lot of other people's, and we share the gains and losses proportionately.

But facts like these may come as a surprise:

Only one of five mutual funds has been around for more than 25 years.

The nation's 7,600 mutual funds held $11.1 trillion in assets at the end of 2,009, up from $370 billion 25 years before.

Money market funds, which are often treated as extremely liquid investments, may hold securities whose maturity date is as long as 397 days.

If you find that a fund's prospectus is not detailed enough, you can ask for a ''statement of additional information'' (which turns out to be mostly legal boilerplate).

These facts come courtesy of Robert Pozen and Theresa Hamacher, the authors of ''The Fund Industry''(Wiley, $75). It isn't a book of mutual fund trivia; rather, the authors have created a comprehensive text for understanding how mutual funds function day to day. You can think of the book as mutual fund information for your inner nerd. (To prove it, there is a sidebar, called ''A Day in the Life of the Fund Accountant.'')

Mr. Pozen is the chairman emeritus of MFS Investment Management, which points out on its Web site that it invented the first mutual fund in 1924. Ms. Hamacher is the president of the National Investment Company Service Association, an organization of service providers to the mutual fund industry.

The authors are not writing here about how to invest in various funds -- the personal finance component of this 525-page book makes up only a small fraction of the work. Instead, their focus, as the subtitle makes clear, is ''how your money is managed.'' They explain the legal requirements governing funds; what fund managers actually do day to day, and the roles played by transfer agents and the like. In short, it answers many questions you might have about the nature of your fund investments.

This is the third version of the book, and the first on which Ms. Hamacher has worked. But the authors say that this isn't just an update of the last edition, which was published in 2002 under the title ''The Mutual Fund Business'' (Houghton Mifflin, $136.95).

They have, for example, added a chapter about money market funds, another that combines a discussion of exchange-traded funds and hedge funds, and two more about the global fund industry.

They fill the book with short sidebars that explain fund terms you may see all the time but can't precisely define. Things such as NAV -- ''a fund's net asset value pronounced as one syllable rhyming with 'have' equals fund assets minus fund liabilities divided by the number of share outstanding.''

There are also simple graphs that explain complex concepts like a yield curve, as well as interesting and occasionally droll asides like this: ''Defined-contribution plans overseas are often referred to as schemes -- a term that doesn't have the negative connotation abroad that it has in American English.''

The book also contains detailed behind-the-scenes reports. For example, the authors walk you through what happens from the time you place an order to buy mutual fund shares until they arrive in your account.

Despite its comprehensive nature, the book has three failings.

It doesn't devote much space to the downside of investing in mutual funds. The book does cite these drawbacks: fees, which may sometimes be excessive; the inability of individual investors to control the timing of capital gains or losses in a fund; and the relative unpredictability of the dividends and income produced by funds, compared with individual stocks or bonds. But those negatives aren't explored fully.

And while the authors are terrific at defining terms and explaining the regulations governing funds, there are places where they could have done more to point out areas where investors should be wary.

For instance, in discussing limitations set by the Securities and Exchange Commission on what a fund can be named -- ''Rock Solid or Super Safe would never pass muster'' -- they say that if a mutual fund contains ''foreign'' in its name, it is required to have at least 80 percent of its investments in securities tied to countries outside the United States. That means that a fifth of the assets, a fairly large amount, can be held in domestic companies -- a point that might have been made explicitly.

BUT the biggest flaw is the decision not to discuss at length the subject of derivatives, that vast array of financial instruments based on other assets.

Standard futures contracts and options are derivatives, but more esoteric versions played an important role in the 2008 credit crisis and subsequent stock market plunge. The authors say that ''space was simply too short to do justice to this complex topic.'' That's disappointing, especially because, elsewhere in the book, the authors were able to provide in a single page the best fundamental discussion of investment risk I have ever read.

Still, the book is more than worthwhile. It may not answer all of your questions about how to find the best mutual funds, but it certainly makes the recommended reading list.